S Corp vs C Corp: What's the Difference?

When incorporating a business in the United States, one of the primary decisions is whether to choose an S Corporation or C Corporation. While these two types of corporations have some commonalities in their basic structure, there are also some important differences to be aware of.

These differences primarily pertain to taxation and ownership requirements. The right type of corporation to choose will depend on the specific situation and needs of the business. 

Historical Evolution

Understanding the evolution of corporate structures can shed light on why S Corps and C Corps exist in their current forms. Traditionally, the C Corporation was the default structure for incorporated businesses in the United States. For much of American business history, corporations were designed to facilitate large-scale investments, expand operations, and limit owner liability—all while subjecting profits to corporate income tax.

In contrast, the S Corporation designation emerged as a response to the needs of smaller businesses and family-run enterprises. Introduced by Congress in the late 1950s, the S Corp election allowed qualifying companies to avoid the double taxation inherent in the traditional C Corp model by enabling profits and losses to pass through directly to shareholders’ personal tax returns. This change was a significant legislative response to the desire for more equitable tax treatment of small businesses.

Over the decades, legislative amendments—including revisions made during the Tax Reform Act of 1986 and subsequent modifications—have continuously shaped these structures. The evolution of tax laws and regulatory requirements has been driven by shifting economic priorities, the growth of the startup ecosystem, and the need to balance corporate governance with fair taxation. Understanding this historical backdrop not only clarifies the rationale behind each structure but also helps businesses gauge which model aligns best with their long-term goals.

What Is a Corporation?

A corporation is one of the most common types of business structures, along with Limited Liability Companies, Sole Proprietorships, and Partnerships. In order to form a corporation, you must prepare a document known as the “articles of incorporation” and file the relevant registration documents with state authorities. Owners of a corporation are known as shareholders, who elect directors to oversee and run the business.

The profits of a corporation are distributed as dividends to its shareholders. A corporation is a separate legal entity which offers limited liability protection to its owners. These basic features of a corporation are common for both S Corps and C Corps.

S Corp vs C Corp Similarities 

S Corporations and C Corporations have many features in common, including:

1. Limited liability protection - They are both owned by shareholders who are legally separate entities from the corporation. This means that both types of corporations provide limited liability protection to their owners.
2. Document filing - Both are formed by filing the articles of incorporation.
3. Basic requirements: Both must fulfill the basics of a corporation issue shares, hold annual director and shareholder meetings, file annual reports, pay annual registration fees to the state. 
4. Separate legal entities - both S Corp and C Corp entities are separate legal entities

S Corp vs C Corp Differences

The main differences between an S Corp and a C Corp can be broken down into three categories.

1. Formation

All newly formed corporations are automatically designated as C Corporations when you file the articles of incorporation. The only way to form an S corporation is to convert an existing C Corporation by filing form 2553 with the Internal Revenue Service (IRS).

Depending on the state, there may be additional state forms to file in order to be granted S Corp status for tax purposes. The consent of all shareholders is required to convert a C Corporation into an S Corporation. 

In terms of formation requirements, a C Corporation is naturally simpler as it requires less paperwork and no additional complexity to convert it.

2. Taxation

The primary benefit of an S Corporation over a C Corporation is taxation. 

C Corporations are effectively subjected to double taxation because they are treated as separate legal entities for tax purposes by the IRS. This means that the C Corporation itself incurs corporate income tax on its profits. These after-tax profits are distributed to shareholders as dividends, which in turn incur dividends tax on each shareholder's personal tax returns. 

S Corporations, on the other hand, allow the owners to avoid this double taxation. S Corps benefit from “pass-through” taxation, whereby all profits and losses are passed directly to the shareholders and are therefore not taxed at the corporate level. The shareholders are directly liable to pay taxes at the personal level. This is similar to the taxation structure of a sole proprietorship or partnership, but with the limited liability benefits of a corporation. 

Importantly, fringe benefits provided to shareholders (e.g., life and disability insurance, health cover, etc.) are not tax-deductible in the case of an S Corp, but may be for C Corps.  

3. Ownership

The primary benefit of a C Corporation over an S Corporation is greater flexibility in ownership.

A standard C Corporation does not have any restrictions on ownership. The corporation can have an unlimited number of shareholders, issue various classes of shares, its owners can reside anywhere in the world, and can be any legal or natural entity. 

In contrast, a corporation that chooses to convert to an S Corp has a number of ownership restrictions:

• It is permitted to have a maximum of 100 shareholders
• It is only allowed to issue one class of share (i.e. all shares are equal)
• All shareholders must be US citizens and residents
• Shareholders must be natural persons. It cannot be owned by separate legal entities such as another company or a trust

The greater flexibility in ownership enjoyed by C Corporations makes them more ideal for larger companies looking to expand globally, or to offer multiple classes of shares to a large number of investors.

The owner restrictions of an S Corporation are only a disadvantage if it does not align with the objectives of the business and shareholders.

Advantages & Disadvantages

S Corporation Advantages

1. Taxation: An S corp does not have to pay any corporate tax. Taxation occurs at the individual level and not on a corporate level.
2. Pass-through structure: An S corp passes all taxes as well as benefits and losses onto its shareholders (losses can be used to offset income)
3. Income deduction: S corp members can claim a deduction of 20% for business income

C Corporation Advantages

1. Shareholders: No limit on the number of shareholders
2. Taxation: The corporate tax rate is at a flat 21% which remains nearly 50% lower than the highest marginal personal tax rate
3. Capital: Easier for C corporations to obtain financing

S Corporation Disadvantages

1. Shareholders: S corporations can only have 100 shareholders which limits their ability to go public and raise capital
2. Restrictions: All shareholders of an S Corp must be individuals as well as U.S. citizens or residents. 
3. Transfer: Shareholders have a hard time selling shares making it more difficult for shareholders to exit.

C corporation disadvantages

1. Taxation - C corporations are double taxed, meaning that the corporation is taxed on earnings and then all individuals have to pay tax on dividends
2. Restrictions - C corps have more regulations and oversight then many other tyes of companies as there are complex rules that govern the entity
3. Deduction - There is no detection of corporate losses, which means that shareholders can not deduct losses on tax returns unlike an S Corp

Which Should You Choose?

Deciding on whether to stick with a C Corporation or have your business converted to an S Corporation is dependent on your situation and specific requirements. There are a number of factors to consider before making the final decision:

1. Company acquisition: If you intend to sell the company at some point in the future, a C Corporation may be the better option. C Corporations can be acquired by any legal entity from any country, and have no restrictions on the number of owners. This makes acquisitions easier and more attractive to prospective shareholders.
2. Scope for expansion: S Corporations are limited to 100 shareholders which obviously limits the scope for significant expansion. If your aim is to have a small or medium-sized corporation with greater input and participation from the shareholders, then an S Corporation is the right option for you. If, however, you wish to expand the business significantly, you might decide to rather choose a C Corporation.
3. Taxation: The major reason for opting to convert to an S Corporation is to eliminate corporate taxes. For smaller corporations who don’t require the additional ownership flexibility of a C Corporation, it makes sense to go through the added process of converting to an S Corporation, as it can result in significant tax savings. 
4. Regulatory scrutiny: There are strict requirements which S Corporations must adhere to, and as such they are subjected to a greater amount of regulatory scrutiny. It is important to clearly understand the requirements and follow them to the letter.
5. Other options: Finally, before deciding whether to incorporate an S Corporation or a C Corporation, it is worthwhile also considering the various other types of corporate entities available, as you may find that one of them suits your needs even better. These include LLCs, Sole Proprietorships, and Partnerships.

The aforementioned factors should help you to make an informed decision about whether an S Corporation or C Corporation is best for you.

Conclusion

Overall, an S Corporation is the preferred choice for smaller businesses who already fit within the legal restrictions of an S Corporation, as it can help them to save on taxes without any structural changes to the business. C Corporations are preferred by larger businesses who wish to expand globally and have a large number of shareholders.

FAQ

Q: Can an S Corporation be converted back to a C Corporation?
A: Yes, an S Corp can convert back to a C Corp. However, this decision should be made with careful consideration of the potential tax implications, such as the impact on built-in gains and accumulated earnings. Consulting a tax professional is advised before making the change.

Q: What happens if an S Corporation exceeds 100 shareholders or has ineligible shareholders?
A: If an S Corp violates any of its eligibility requirements (such as exceeding the 100-shareholder limit or including ineligible shareholders like non-U.S. residents or corporations), it risks losing its S Corp status. This would subject the business to C Corporation taxation, potentially resulting in double taxation on dividends.

Q: Are the corporate formalities the same for S Corps and C Corps?
A: Generally, both S Corps and C Corps are required to follow similar corporate formalities—such as holding annual meetings, keeping minutes, and filing annual reports. However, C Corps, especially those that are publicly traded, may face more stringent reporting and governance requirements.

Q: What are the potential penalties for non-compliance with corporate governance standards?
A: Non-compliance can lead to a variety of penalties, including fines, legal liability, and in severe cases, the loss of limited liability protection (commonly known as “piercing the corporate veil”). Maintaining strict adherence to corporate formalities is essential for protecting both the corporation and its shareholders.

Q: How does the election of S Corp status impact fringe benefits for shareholder-employees?
A: In an S Corp, shareholder-employees who own more than 2% of the company have certain limitations on receiving tax-free fringe benefits. While non-owner employees typically receive benefits on a tax-deductible basis, owner-employees may need to include these benefits in their taxable income.

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